Short Selling's Hidden Power: How It Disciplines Corporate Mergers
"Uncover how the threat of short selling can lead to better merger and acquisition decisions."
In the high-stakes world of corporate finance, mergers and acquisitions (M&A) are critical events that can significantly impact a company's future. While the goal is always to create value, M&A deals can sometimes destroy it, often due to managerial misjudgments or conflicts of interest. This has led to increased scrutiny of the mechanisms that keep managers in check, ensuring they act in the best interests of shareholders.
One such mechanism, often overlooked, is the role of short selling. Short selling involves borrowing shares of a company and selling them, with the expectation that the stock price will decline. If the price does drop, the short seller buys back the shares at a lower price and returns them to the lender, pocketing the difference as profit. This practice is often viewed negatively, but it can serve a valuable purpose in the market.
A new study published in the Journal of Accounting and Economics sheds light on how the threat of short selling can actually improve the quality of M&A decisions. The research suggests that when managers know their decisions will be closely scrutinized by short sellers, they are more likely to pursue value-enhancing deals and avoid those that could destroy shareholder wealth. This article will explore how short selling acts as a powerful, albeit indirect, force for corporate governance.
How Short-Selling Threat Shapes M&A Decisions?
The study leverages the concept of 'equity lending supply' (LS) as a proxy for short-selling threat. Equity lending supply refers to the availability of shares that can be borrowed for short selling. The researchers argue that short sellers are more likely to actively scrutinize a firm if there are plenty of shares available to borrow, as this makes it easier and less expensive to execute short-selling strategies.
- Higher Returns with Higher LS: The study found that acquirers with higher equity lending supply experienced higher announcement returns. This suggests that when managers face a greater threat of short selling, they make better M&A decisions, leading to more positive market reactions.
- Hostile Takeover Defense: The effect of short selling was even stronger when acquirers were more likely to be targets of subsequent hostile takeovers. This indicates that short selling can help to discipline managers who might otherwise engage in empire-building or other value-destroying activities to protect their positions.
- Wealth Sensitivity: The researchers also found that the short-selling threat was more potent when managers' wealth was more closely linked to stock prices. This aligns with the idea that managers are more sensitive to the potential consequences of their actions when their personal financial well-being is at stake.
A New Lens on Corporate Governance
This research provides valuable insights into the complex world of corporate governance. By highlighting the role of short selling, the study demonstrates that external market forces can play a significant role in shaping managerial behavior and improving the quality of corporate decisions. As investors and regulators seek to enhance corporate governance, it is essential to consider the often-unseen influence of short selling and its potential to promote value creation.